The cash turnover ratio is used to determine the proportion of cash required to generate sales. The ratio is typically compared to the same result for other businesses in the same industry to estimate the efficiency with which an organization uses its available cash to conduct operations and generate sales. The formula is:
Annual revenue ÷ Average cash balance = Cash turnover ratio
For example, a business generates $10,000,000 of sales in its most recent year. The average month-end cash balance of the firm was $1,000,000. This means the cash turnover ratio of the organization was 10x per year.
The cash turnover ratio can also be used to estimate the amount of cash that will be needed to fund a projected increase in future sales. Thus, to continue with the preceding example, if there is a budgeted increase of $1,000,000 in sales and the cash turnover ratio is 10x, that means the company will require an additional $100,000 of cash to fund the sales increase.
There are several issues to be aware of that can make this ratio less effective. They are as follows:
- Cash distributions. Some entities routinely eliminate excess balances by issuing dividends or buying back shares. If so, their cash turnover ratios will appear much higher than those of competing businesses whose managers prefer to retain excess cash in the organization.
- Gross margins. If a business is contemplating selling new goods or services that have lower gross margins than its existing product mix, this will require a higher proportion of cash to fund the additional sales. This is because the cost of goods sold will be higher than is currently the case.